Lost Control

I'll try to add some things and get this Bulletin "cleaned up" in
the morning. Thanks!

Stocks ended the week somewhat lower. Managers were apparently focusing on
increasingly favorable economic reports, while working diligently to ignore
major upheaval in interest rate markets. For the week, the Dow Jones Industrials
lost 1.4%, hurt by poor showings from financials Citigroup and JP Morgan. The
S&P500 shed 1.9% this past week. The Transports lost 0.8% and the Utilities
fell 1.8%. The Morgan Stanley Cyclicals were relatively unchanged, while the
Morgan Stanley Consumer index dipped 1.8%. The broader market continued to
outperform, with the small-cap Russell 2000 about unchanged. The S&P400
Midcap index was down only 0.4%. The tech-heavy Nasdaq100 and Morgan Stanley
High Tech indices were down about 1%. The Semiconductors added almost 1%, while
The Street.com Internet index dipped only 0.3%. The Nasdaq Telecom index dropped
1.4% and the Biotechs gave back 0.8%. Especially late in the week, financial
stocks came under heavy selling pressure. The Broker/Dealers and banks were
slammed for 4%. With the volatile bullion sinking $16.80, the HUI suffered
a decline of 2.6% this week.

The dollar index gained almost 2%, while the CRB commodity index rose 1.5%.
Copper traded to a 28-month high this week (up almost 10% during July), as
industrial metals continue to trade impressively.

If not outright chaos, it was close. It was clearly an unmitigated Credit
market rout, capping off the worst month in the Treasury market since 1980
(according to Bloomberg). For the week, two-year Treasury yields jumped 27
basis points to 1.77%, with 5-year yields up 23 basis points to 3.21%. The
10-year Treasury yield surged 21 basis points to 4.38%, while the long-bond
saw its yield jump 20 basis points to 5.32%. The Treasury market, however,
was a picnic when compared to agencies and mortgage-backs. The implied yield
on agency futures surged 46 basis points, while the yield on Fannie Mae benchmark
mortgage-backs spiked 53 basis points. Articles describing trading conditions
used words such as "obliterated" and "unprecedented." The
10-year dollar swap spread (to Treasuries) surged 7.5 basis points today to
66, with a stunning 24.5 basis point widening for the week. Intraday, this
spread today traded to 71, the highest level since March 2002. For comparison,
the dollar swap spread widened a total of 35 basis points (60 to 95) during
the two month Russian and LTCM crisis (August 10 to October 10, 1998). Demonstrating
the clear panic players were having off-loading interest rate risk, December
2004 3-month Eurodollar rates spiked 70 basis points higher this week to 2.93%
(up 103 basis points in three weeks). Not surprisingly, the CME yesterday posted
its highest volume (interest rate futures) on record.

The national ISM Manufacturing index added 2 points to 51.8, surpassing 50
for the first time since February. New Orders added 4.4 points to 56.6, up
10 points from the March low to the strongest reading since January. Prices
Paid declined 3 points to 53. The July Chicago Manufacturing index was reported
at a stronger-than-expected 55.9, up 3.4 points from June to the highest level
since January. New Orders jumped 6.9 points to 61.7, the strongest reading
since last November. Order Backlog was up 3.6 to 49.4, the highest since December.
Curiously, Prices Paid declined 1.2 points to 47.9. The New York Purchasing
Manager's index jumped 2.9 points to 46.2, the highest reading since January.
The Milwaukee Purchasing index jumped 10 to 58, the strongest performance since
last November.

Second quarter GDP was reported at a stronger-than-expected rate of 2.4%,
with y-o-y growth of 2.3%. The "Quality of Output" was nothing to
write home about, with Federal Government "consumption" expanding
at a 25.1% annualized rate (National Defense up 44.1%). Final Sales to Domestic
Purchasers expanded at a notable 4.6%, the strongest showing in more than three
years. Final sales were up from the first quarter's 1.4% and the year earlier
1.3%. Second-quarter Personal Income expanded at a 3.3% annualize rate (up
2.9% y-o-y), accelerating from the previous quarters' 2.4% and 2.1%. And while
Wages and Salaries rose at a 1.9% rate during the quarter, Transfer Payments
increased at a 7.2% rate and were up 6.4% y-o-y. Personal Outlays increased
at a 4.4% clip during the quarter and were up 4.5% y-o-y. Year-over-year compensation
numbers are rather interesting. Civilian Workers total compensation is up 3.7%
y-o-y. Wages and Salaries are up 2.7%, with Benefits up 6.3%. For comparison,
Benefits increased at a 5% rate during last year's second quarter and 4.5%
during Q2 2001.

The Refi index sank 33% last week to the lowest level since December. Refi
applications have now dipped 13% below the year ago level. And while all the
focus is on the Refi index, we'll be watching the Mortgage Bankers Association
Application index quite closely going forward. The Purchase index dipped only
3.5% last week, while remaining up 19% y-o-y. In dollar terms, Purchase applications
were up 26.2% y-o-y.

Freddie Mac announced second quarter mortgage refi data. The number of new
loans with a "5% higher loan amount" declined 9 basis points to 32%.
The "median appreciation of property" dropped to 3% from the first
quarter's 7%. For comparison, last year's second quarter saw 63% of new loans
for 5% or higher, with average appreciation of 20%.

The F.W. Dodge Construction Activity index surged 12 point in June to 159,
a new record high.

Four of the major mortgage real estate investment trusts (REITs) that we follow
have reported second quarter balance sheets posted combined 83% annualized
growth during the second quarter to $44.5 billion. Year-over-year assets were
up 63%.

Returning to my "weathered" flood insurance analogy, I have excerpted
from the March 14th Bulletin, "Climbing the Wall of Water":

"...the community made it through the panic after a bold government official
guaranteed that the authorities would "take extraordinary measures" to
stop the flood waters before damage initiated a vicious spiral of financial
and economic collapse. The authorities began working frantically up the river,
using whatever materials and means available to construct dykes, dams and levees.
These efforts saw the river level recede and, quite favorably, the rain let
up for a few months... The players sleep well at night with the knowledge that
the authorities are on the case -- up the river working diligently to hold
the water at bay. Down river in the community, the water level rises only minimally.
And, much to the delight of everyone, the insurance market remains open for
business and prices remain uncharacteristically stable. The trepidation and
angst that had become the rainy day norm has been replaced by calm and optimism.
(Those incessant naysayers are shocked by the complacency) What's more, in
the midst of the rainy season the community is emboldened to increase construction. With
the river level rising only moderately and the insurance market functioning
splendidly, the litany of homeowners, builders, bankers and insurers come to
a consensus that it has become practical to build well inside the 100-year
flood plane. The insurers are emboldened by now tested assurances from the
authorities - they promised and delivered... And while the energized community
gets back to business as usual, up the river the make-shift dams and levies
grow only taller and less stable."

A great deal has transpired since those dark days last October when Team Greenspan/Bernanke
too successfully reversed an unfolding Credit crisis. In the above analogy,
the river level only "grows taller and less stable" over time. In
real life, it's the mortgage-related securities mountain rising relentlessly
to the heavens. I will throw out a rough estimate of $750 billion of Total
Mortgage Credit growth during the past nine months (at artificially low interest
rates), more than double the growth from the entire year 1997. We have witnessed
the great Mortgage Finance Bubble go to historic "blow-off" extremes.
We are now beginning to pay what will be a very heavy price for reckless excess.

Understandably, Fannie Mae Chairman Franklin Raines has been quick to blame
Freddie's accounting snafu for recent market turmoil. However, the root of
the problem lay elsewhere: unparalleled Credit expansion and the resulting
securities Bubble, replete with unprecedented leveraging, speculating and hedging
activities. To try to put the dimensions of the bursting Bubble into perspective,
recall that Fannie and Freddie's combined Book of Business has more than doubled
since the beginning of 1998 to almost $3.3 Trillion. Moreover, Fannie expanded
its Book of Business at an unprecedented annualized rate of $460 billion, or
26.8% annualized, during this year's first half. Of this, outstanding mortgage-backs
surged at a $416 billion annualized pace, or an astonishing rate of 44.5%.
Bloomberg's tally of mortgage-backed security issuance has $1.5 Trillion of
(gross) new securities created from last October through this June. There's
never been anything like this, with the household sector winning a huge interest
rate bet (with Fed-induced artificially low mortgage rates). Now, the financial
sector sinks only deeper under water. From Fannie, we see a 5.22% average "net
yield" for mortgages purchased so far this year. Benchmark 30-year mortgage
rates jumped to 6.14% this week.

Extending the flood insurance analogy, the confidence instilled by the authorities' "desperate
measures" assurances led to an unprecedented building boom right along
the river's edge. Caution was thrown to the wind. The amount of systemic risk
quietly ballooned exponentially. Moreover, the emboldened insurance marketplace
became absolutely transfixed by manic irrational exuberance. Writing flood
insurance was recognized as virtually "free money" and lots of it
was there for the easy taking. Speculation ran rampant. Players operated with
the assumption that, in the very low probability that flood waters began to
rise to dangerous levels, they would simply and inexpensively hedge flood risk
in the (liquid) reinsurance market (with rates collapsing post-"assurances").

Curiously, there was little concern when the river again began to rise. There
was actually a virtual stampede by the speculator insurance players to write
more insurance when prices began to increase. More "free money," courtesy
of our able authorities. Apparently, with many false flood alarms over the
years - and especially knowing that the authorities were on the case - the
marketplace had been afflicted with a grave case of greed and complacency.

Looking back, it seems only reasonable that someone would have asked a few
basic questions: First, how much insurance has been written? Second, what is
the financial wherewithal of the insurance industry? Third, how will the insurance
market operate in the event of heightened risk of a catastrophic flood? Instead,
with crises always having been averted in the past, it was assumed that the
insurance market was sound and stable. Somehow, the authorities were only concerned
with holding the water at bay so the building boom could be sustained along
the river.

After a few weeks of casually watching the water level rise moderately along
the riverbank, some concern began to set in. Yet the marketplace remained relatively
calm, appreciating that the authorities were apparently still operating on
the dykes, dams and levees up the river. Besides, the water was still significantly
below dangerous flood stage. A few of the more sophisticated players, however,
became a little unnerved when talk spread that the authorities had decided
to let some water run from the levees, seemingly to relieve building pressure.
Were the authorities having second thoughts on their strategy? Or perhaps there
were problems up the river that were being kept under wraps. Do the authorities
have a viable "end game"?

Then a very unusual thing then developed: the price of reinsurance began to
rise dramatically and inexplicably. The herd of insurance writers/speculators
all had monitors where they followed the river level to the quarter inch, by
the second - green flashes when the river rises, red when it declines. And
while they were for awhile comforted that the river remained well below flood
stage, they were mystified by the steadily rising cost of reinsurance. What
had changed? Looking back, it is difficult to pinpoint the day that Greed turned
to Fear; it just happened. All of the sudden, a few speculators recognized
that the cost of reinsurance was becoming so prohibitive that they risked insolvency
with any further delay in hedging their exposure. Having already written significant
insurance during the recent boom, the limited number of seasoned sellers of
reinsurance immediately backed away from the marketplace. Prices spiked. And
while many worked to calm the market with the "analysis" that flood
fears were overblown, almost overnight panic overwhelmed the reinsurance market.
Everyone suddenly realized they were on the "same side of the boat," and
market dislocation was unavoidable if any serious flood risk unfolded. Over
the life of the boom there had developed massive flood risk, and there were
grossly insufficient resources to render this market viable.

I'll leave our analogy this week with confidence throughout the flood insurance
marketplace firmly shaken. And while the savviest insurance operators now appreciate
that the insurance business has in reality been destroyed by the explosion
of risk and the proliferation of speculation, this is certainly not the consensus
view. Most expect reinsurance rates to quickly reverse as they always do - where's
the devastating flood? The river level remains, after all, significantly below
flood stage. The only losses "suffered" to date are "on paper." The
issue then becomes, will the speculator herd race to the exits or, as they've
done successfully so many times before, be enticed to only raise the size of
their bets? Interestingly, word of the major tumult wreaking havoc on the insurance
market goes largely unnoticed by the ebullient homeowners and builders (they're
still celebrating the post-"assurances" boom-let). Citizens have
grown accustomed to rising waters, and are well-conditioned to stay focused
on the job at hand: growth along the river. Ironically, considering the rising
waters, the fiasco unfolding up with the authorities up river, and the near
cataclysm in the insurance market, confidence runs high in the community.

Returning to reality, major tumult overwhelmed the Credit market this week.
Despite Treasury bond option volatility reaching the highest level since LTCM
and panic selling gripping the marketplace, yesterday's developments didn't
even muster one of the 15 "Top Stories" on Bloomberg News in the
evening. The stock market responded only by giving up the majority of its earlier
160 point gains. Bullish pundits were quick to explain that bond market weakness
was confirmation of the recovering economy. I see no recognition that we have
abruptly returned to near systemic crisis.

Not since 1994 have we seen such a dramatic jump in interest rates, although
nothing compares to the hastiness of the recent rate spike. Wow! It has clearly
caught many a leveraged speculator, many an aggressive bank, many a Wall Street
proprietary trading desk, many a REIT, and likely the major derivative players.
The markets to off-load interest rate risk have dislocated. The mortgage-backed
market is in disarray and it would appear the same can be said for the interest
rate derivative markets generally. 1994 saw a few sophisticated (mortgage securities) "market
neutral" hedge funds blow up, the big "macro" funds suffer significant
losses, and myriad derivative losses. Later in the year, Orange County filed
bankruptcy after suffering huge losses on structured notes, most issued by
the government-sponsored enterprises (at least they proved good interest rate
hedges for the GSEs). It concerns me greatly that this is nothing like 1994's "flood
with some homes along the river." There's been an historic 10-year building
boom that's completely changed both the environment and the marketplace. Previous "100
year floodplains" are meaningless at best. .

All the same, it is today surely not all too difficult for the bulls to think
back to 1994 and sleep comfortably at night. It was a ravaging bear bond bear
market, but the system made it through with only (in hindsight) a good scare.
For the equity market, it proved an early hiccup preceding one of history's
great bulls - a truly great buying opportunity. Yet there was a key unappreciated
development that I believe played a crucial role in saving the day back during
1994, back when the impaired leveraged players were unwinding positions and
the risk of a systemic liquidity crisis ran high. The financial sector, especially
the "fledgling" government-sponsored enterprises, enjoyed the capacity
to expand Credit aggressively. And they did expand, aggressively.

Indeed, despite a major Credit market cataclysm, the Financial Sector managed
record Credit market borrowings of $468.4 billion during 1994, up 14% for the
year. This compares to Financial Sector borrowings of $292.4 billion during
1993 and $244 billion during 1992. Importantly, Federally Related Mortgage
Borrowings (the GSEs and mortgage-backed securities) increased Credit by $287.5
billion, up from 1993's $165.3 billion. The GSE's expanded Credit market
borrowings by an unprecedented $150.7 billion, or almost 24% during 1994.
This was double 1993's growth and was almost the amount of expansion over the
previous three years. The GSE-led financial sector was successful in generating
sufficient Credit creation to "paper over" the liquidity problem.
In the process the GSEs ushered in the Great Credit Bubble.

But 1994 today appears a modest little hill when compared to 2003's Mountain.
Total Credit Market Debt has ballooned from 1994's $17.2 Trillion to today's
$32.5 Trillion. Total financial sector borrowings have ballooned from $3.8
Trillion to $10.5 Trillion. Total Mortgage Credit has ballooned from 1994's
$4.4 Trillion to today's almost $9 Trillion. At the same time, the leveraged
speculating community has absolutely mushroomed. Is it feasible that the financial
sector, after almost doubling in size over five years, has today the capacity
to expand sufficiently to sustain the financial and economic Bubbles, while
playing buyer of last resort to the de-leveraging speculator community? It
is not readily apparent to me that this can occur.

All facets of the Credit system have been firing on all cylinders, with resulting
massive Credit growth barely sustaining the Bubbles. The banking system, the
GSEs, the Wall Street firms, the REITS and the hedge funds have all ballooned
over the past few years. Who, then, today has the capacity to take risk from
the scores of speculators looking and needing to offload? Well, the explosion
of the interest rate derivative market has never made much sense. Somehow the
GSE and mortgage securities are apparently able to balloon forever, with players
enjoying the capability to easily and inexpensively hedge interest rate risk.
But to whom? Who is going to take the other side of the interest rate trade
- a "trade" that is ballooning in size and must continue to balloon
to ward off a serious risk of Credit collapse? That is the question. One thing
appears clear today, the Fed has lost control of the interest rate market,
with ominous portents for the highly leveraged and speculation-rife U.S. Credit
system.